If you are like most business people, CPAs, brokers or investors, you probably take the actual business selling prices as a strong indication of what a similar business is worth.
In fact, the market approach to business valuation relies on such selling prices comparisons for a good reason:
Business selling prices offer an objective evidence of how other business people determine the value of businesses.
A large enough number of arms-length business sales is also a good way to establish the fair market value of your business. This is useful even if you do not plan to buy or sell the company.
Here are some key situations where the fair market value is the de-facto standard for business appraisal:
- Gift and estate taxes
- Divorce and other legal disputes
- Buy-sell agreements
- Employee stock ownership plans (ESOPs)
That said, the question is this: just how well do the recent selling prices of similar firms represent the value of your business?
Business selling price: key elements
First, some points about the elements that can make up the business sale price:
- Buyer down payment
- Seller financing
- Lender financing
- Key employment agreements
- Non-compete agreements with outgoing management or owners
Whether all these elements exist in a given business sale deal can make a material difference to the contract business selling price.
Business market value is affected by deal financing
In just about any industry, seller-financed deals tend to result in higher selling prices. If the deal can be financed through a commercial bank loan on attractive terms, the business selling price is likely to reflect it as well.
Typically, the business selling price includes the seller and lender financing at face value, i.e. not discounted over the time it is paid off. Arguably, the cash value of a financed deal is lower than an all-cash business sale.
Earnouts are usually excluded from the business selling price
By convention, the earnouts are excluded from the broker-reported business sale price. That’s because the earnout is contingent upon some future events and may not be paid in full measure or not at all – if the business fails to achieve the objectives agreed upon between the seller and buyer.
Other valuable parts of the business selling price
On the other hand, the employment and non-compete agreements with management and key staff are usually included in the selling price.
Private business value is determined based on total invested capital
Another important rule in valuing small businesses is that the value is established on the total invested capital basis. This includes both the owners’ equity and long-term debt.
That is very different from the public company valuation multiples that are typically computed on the owners’ equity basis only. If the company being valued uses debt financing, the resulting valuation results can be very different!
Get a defensible business value number by following established conventions
Since these conventions are followed by most professional business appraisers, it is wise to stick with them – if you want to avoid the challenge by other business people, tax authorities or courts.
Check your valuation multiples
Valuation multiples derived from market comps are the tools you can use to estimate your company’s fair market value. You can calculate it in relation to your firm’s financial performance such as revenues, gross and net profits, EBIT, EBITDA, business assets or owners equity.
When you use such valuation multiples, you need to be aware how they are calculated. Otherwise, your business value estimate may be way off.